analyzing the possibilities

[jk]

a friend sent me an email with a passage from an interview published this weekend, asking for comments. i decided to post the exchange here:

my comments are interspersed

Have you done your annual portfolio reviews and come up with a 2008 outlook?
Yes. We just finished it. Our operative scenario is that there is a 55% probability that the reflating of global rates serves as a catalyst for lower liquidity, slower growth, and an increase in risk premiums. U.S. growth slows from 2007's pace and continues below its potential through 2008, thereby elevating pressure on resource utilization rates and allowing inflation to continue to recede. Housing remains a headwind for the domestic economy but does not cause a recession, and excess inventory is slowly reduced. Unemployment drifts higher as firms focus on reducing costs. Capex [capital expenditures] remains a source of strength. The Fed cuts rates to 4½%. In that scenario, we get a market that is 15%-18% undervalued.

this mainline, 55% prediction, is similar to john mauldin's "muddle through" prediction of below-potential, sluggish growth for several years.

my own impression is that housing inventory is likely to continue to rise for at least another year as pre-ordained mortgage resets peak in q-4 2007 and q-1-2 2008, and the foreclosure process takes 6-12 months to play out. at the same time, new construction is still ongoing to finish partially completed projects in which there are sunk investments that will only be recouped on completion and sale. the desperate need for builders to sell new home inventory is driving prices lower - the builders are now offering up to 30% discounts from prior pricing, not including the cost of incentives [upgraded counter tops, appliances, etc]. this, along with the increasing flow of foreclosed properties, will keep home prices on a downward course even as existing-home owners are reluctant to sell at market clearing prices. since about half of the increase in consumption in each of the last several years is accounted for by home equity withdrawals, the loss of this source of funds will at least slow, if not reverse, the growth of consumption. in the meantime, high energy prices in the form of increased costs for transportation, and heating and cooling, as well as higher food prices, will continue to reduce consumers' discretionary income.

until quite recently financials comprised about 25-20% of the s&p iirc, and contributed an even higher proportion of s&p profits. i don't believe that the credit crunch is over, and i think this means that financials' profits are very much in doubt. the abcp market is evaporating as paper matures and is not rolled over. the mortgage securitization market is moribund, and non-conforming mortgages have become expensive. the spike in libor during the recent unpleasantness revealed the latent skepticism the banks have of one anothers' solvency, especially since they don't know how to value their own assets, let alone anyone else's. the m-lec proposal is a way to provide an artificial price for the higher rated cdo tranches the banks' siv's still hold, and at the same time allows them to keep this stuff from migrating from those off-balance-sheet siv's onto their own books. if m-lec doesn't accomplish this, having to carry these "assets" will further constrict the money-center banks' ability to lend.

it's hard to see financials continuing to contribute to s&p earnings the way they have in the past. i see no reason to believe that the write-downs are over. merrill's US$7.9 billion may well be only a first installment. iirc it was only a couple of months ago that merrill said it would be under US$5 billion. what will they say in another 2 months, the end of the calendar year? i haven't seen much lately about the clo market. some previously committed pe deals have gone through, but where are the new announcements? i think the market has lost the pe take-out bid. retail stocks have started to go down, and in general it's hard to see the consumption oriented names maintaining profits.

so i don't know how these guys [susan byrne, actually, in this weekend's barrons] say that the sluggish-growth scenario leaves the market 15-18% undervalued. i presume this valuation is based on the somewhat lower rates they predict, but i don't think they've accounted for mean-reverted [they've been at record heights], lower profits. so even if slow-growth is the most likely scenario, i don't see how that supports market valuations higher than we now have. i think the slow-growth scenario supports lowered equity valuations.

more below.

We don't do this exercise to be right; we do it to assess risk. There is a 25% probability, we call it our gloom-and-doom scenario, that losses from housing and real estate accelerate, putting additional pressure on the U.S. economy and the global financial system. The U.S. enters a recession as job losses surge, resulting in massive credit losses in all consumer-related areas. All lending is sharply curtailed as financial institutions struggle with impaired balance sheets. The global economy slows sharply as exports to the U.S. fall and foreign investors realize significant losses on U.S. investments.

In this scenario, the Fed aggressively cuts rates to 1½% on the Fed-funds rate and 3% on the 30-year. There is a collapse in commodity prices. In that environment, our highest investment return would obviously be in long bonds, where we would see a 30%-plus return in contrast to a negative 18%-to-22% one-year return in the equity market.

i don't see why her "gloom-and-doom scenario" leads to lower long-term rates, i.e. "our highest investment return would obviously be in long bonds." it's not "obvious" to me. i know that historically when the economy slows and the fed cuts short rates, long rates have followed. however, i think we are likely to see a "reverse conundrum." you recall that greenspan labelled as "a conundrum" the fact that long rates stayed low even as the fed hiked short rates. my own reading of this is that long rates were held down by the recycling of the trade deficit into treasuries. higher short rates tended to support the dollar. the dollar index slowly declined, but that index is 50% euro, and the dollar held up much better against the yen and yuan, the currencies of the main dollar recyclers. at the same time the yen carry trade remained profitable, and could be made even more profitable by creeping out a bit on yield curve. this latter trade remained profitable as long as longer dated instruments didn't sell off, i.e. as long as the conundrum persisted. so the conundrum had momentum - as long as it persisted, it encouraged a duration carry trade which tended to maintain the conundrum. as u.s. consumption slows, so will imports. this is a double whammy: foreign exporters will not have so many dollars to recycle, as the u.s. market itself becomes less attractive and less worth pursuing via nation state level vendor financing. during the recent credit market scare the yield curve steepened sharply, via short rates dropping. long rates didn't drop, and even rose a bit.

so in the "gloom-and-doom scenario," when the fed drops rates to 1.5% on fed funds, what will the dollar do? unless there is a globally coordinated rate drop, the dollar has to drop sharply. of course, the boj can't join the party even if there is such coordination- they can't drop below zero. so there is market turmoil, equities are postulated [by byrne] to drop about 20%, the yen carry trade looks a lot less attractive, and - in this recession scenario - both the boj and pboc have many fewer dollars to recycle. but this is a recession scenario! what happens to the federal deficit? borrowing needs increase even as fewer dollars are need to support a shrinking trade deficit. i think all this adds up to a reverse conundrum: long rates will hold or even rise as the fed drops the fed-funds rate sharply. so if you want to hedge the "gloom-and-doom" scenario, don't do it with long bonds. just hold cash or perhaps hold zeros with a duration no longer than about 5 years.

of course, given my bearish dispositon i think the odds of this scenario are higher than byrne's postulated 25%.

Any other scenarios in between?
There is a 15% probability -- and two weeks ago it was the prevailing notion -- that despite domestic troubles, demand would remain the same outside and exports would be strong. A weaker dollar results in significantly higher import prices, which along with persistently high commodity prices pushes inflation higher. So we have high interest rates, Fed funds are high, inflation is high, but materials still continue to do well.

i think this scenario is the most complex, and therefore the most interesting one to contemplate. in essence, this is the decoupling scenario - the u.s. slows but the rest of the world chugs along. one interesting sentence is: "A weaker dollar results in significantly higher import prices, which along with persistently high commodity prices pushes inflation higher." i'm not sure that officially calculated inflation will rise very much in this scenario. high commodity prices push up energy and food, which are already up a lot, but it doesn't make it into the numbers because of the focus on "core" numbers. the broader rise in import prices might make it into the numbers, but the bls's use of substitution effects will ameliorate any feed-through into the official rate. in general, unless we see wages going up strongly, i don't see how we get official inflation rising very much. so i think the fed will remain well behind the curve on inflation-fighting, and fed funds won't be all that high. materials and exporters and multinationals should do relatively well in this scenario. but i 'm not sure that this scenario is possible at all - if the u.s. has a recession, or even just slows sharply, will the reduction in import demand be compensated for by increased consumption somewhere else in the world? i don't see it. not without a difficult transition that looks more like the gloom-and-doom scenario.

What's the best-case scenario?
We have a 5% probability that everything is just wonderful. Somebody always has to remind us this is a possibility. But in that scenario, interest rates move up very sharply and Fed funds have to be moved up to 7%, because we never slowed down, and the return on stocks is zero to 5% because we assume a contraction in the P/E because of interest rates and inflation.

i agree with this part of her analysis. i, too, have to be reminded of this possibility -- because i don't think it's going to happen.

[GRG55]

Re: analyzing the possibilites

...

We don't do this exercise to be right; we do it to assess risk. There is a 25% probability, we call it our gloom-and-doom scenario, that losses from housing and real estate accelerate, putting additional pressure on the U.S. economy and the global financial system. The U.S. enters a recession as job losses surge, resulting in massive credit losses in all consumer-related areas. All lending is sharply curtailed as financial institutions struggle with impaired balance sheets. The global economy slows sharply as exports to the U.S. fall and foreign investors realize significant losses on U.S. investments.

In this scenario, the Fed aggressively cuts rates to 1½% on the Fed-funds rate and 3% on the 30-year. There is a collapse in commodity prices. In that environment, our highest investment return would obviously be in long bonds, where we would see a 30%-plus return in contrast to a negative 18%-to-22% one-year return in the equity market.

i don't see why her "gloom-and-doom scenario" leads to lower long-term rates, i.e. "our highest investment return would obviously be in long bonds." it's not "obvious" to me. i know that historically when the economy slows and the fed cuts short rates, long rates have followed. however, i think we are likely to see a "reverse conundrum." you recall that greenspan labelled as "a conundrum" the fact that long rates stayed low even as the fed hiked short rates. my own reading of this is that long rates were held down by the recycling of the trade deficit into treasuries. higher short rates tended to support the dollar. the dollar index slowly declined, but that index is 50% euro, and the dollar held up much better against the yen and yuan, the currencies of the main dollar recyclers. at the same time the yen carry trade remained profitable, and could be made even more profitable by creeping out a bit on yield curve. this latter trade remained profitable as long as longer dated instruments didn't sell off, i.e. as long as the conundrum persisted. so the conundrum had momentum - as long as it persisted, it encouraged a duration carry trade which tended to maintain the conundrum. as u.s. consumption slows, so will imports. this is a double whammy: foreign exporters will not have so many dollars to recycle, as the u.s. market itself becomes less attractive and less worth pursuing via nation state level vendor financing. during the recent credit market scare the yield curve steepened sharply, via short rates dropping. long rates didn't drop, and even rose a bit.

so in the "gloom-and-doom scenario," when the fed drops rates to 1.5% on fed funds, what will the dollar do? unless there is a globally coordinated rate drop, the dollar has to drop sharply. of course, the boj can't join the party even if there is such coordination- they can't drop below zero. so there is market turmoil, equities are postulated [by byrne] to drop about 20%, the yen carry trade looks a lot less attractive, and - in this recession scenario - both the boj and pboc have many fewer dollars to recycle. but this is a recession scenario! what happens to the federal deficit? borrowing needs increase even as fewer dollars are need to support a shrinking trade deficit. i think all this adds up to a reverse conundrum: long rates will hold or even rise as the fed drops the fed-funds rate sharply. so if you want to hedge the "gloom-and-doom" scenario, don't do it with long bonds. just hold cash or perhaps hold zeros with a duration no longer than about 5 years.

of course, given my bearish dispositon i think the odds of this scenario are higher than byrne's postulated 25%.

Any other scenarios in between?

There is a 15% probability -- and two weeks ago it was the prevailing notion -- that despite domestic troubles, demand would remain the same outside and exports would be strong. A weaker dollar results in significantly higher import prices, which along with persistently high commodity prices pushes inflation higher. So we have high interest rates, Fed funds are high, inflation is high, but materials still continue to do well.

i think this scenario is the most complex, and therefore the most interesting one to contemplate. in essence, this is the decoupling scenario - the u.s. slows but the rest of the world chugs along. one interesting sentence is: "A weaker dollar results in significantly higher import prices, which along with persistently high commodity prices pushes inflation higher." i'm not sure that officially calculated inflation will rise very much in this scenario. high commodity prices push up energy and food, which are already up a lot, but it doesn't make it into the numbers because of the focus on "core" numbers. the broader rise in import prices might make it into the numbers, but the bls's use of substitution effects will ameliorate any feed-through into the official rate. in general, unless we see wages going up strongly, i don't see how we get official inflation rising very much. so i think the fed will remain well behind the curve on inflation-fighting, and fed funds won't be all that high. materials and exporters and multinationals should do relatively well in this scenario. but i 'm not sure that this scenario is possible at all - if the u.s. has a recession, or even just slows sharply, will the reduction in import demand be compensated for by increased consumption somewhere else in the world? i don't see it. not without a difficult transition that looks more like the gloom-and-doom scenario.

What's the best-case scenario?

We have a 5% probability that everything is just wonderful. Somebody always has to remind us this is a possibility. But in that scenario, interest rates move up very sharply and Fed funds have to be moved up to 7%, because we never slowed down, and the return on stocks is zero to 5% because we assume a contraction in the P/E because of interest rates and inflation.

i agree with this part of her analysis. i, too, have to be reminded of this possibility -- because i don't think it's going to happen.

The doom and gloom scenario really is, because it means the Feds efforts to create a steep yield curve to bail out the banking system is largely defeated. I would think at the first sign of this outcome Treasury would flood the market with long term bonds to avoid the 3% yield scenario, and the Fed would take administered rates BELOW the previous 1% floor.

Their 25% probability doom and gloom scenario seems the historical norm coming out of previous major bubble-like credit expansions however.

[metalman]

Re: analyzing the possibilities

from twin focus...

All broad based indices have delivered solid year-to-date gains. Despite all of the woes, markets have continued to react with euphoria, topping all-time highs. The market is signaling that the recent turmoil in credit and housing has completely abated.

With the recent deluge in the dollar resulting in large part from the recent rate cuts, most commodities have been touching all-time highs with oil north of $80 / barrel and gold topping $745.

Risk is being repriced, and banks are going to need to deal with the hangover from easy credit and orgy in derivatives and structured products.

The process of securitization has become one of the most important financial innovations in recent years and has produced the alphabet soup of structured credit derivative investments that will preoccupy headlines for some time to come.

The increase in LIBOR rates represents a tightening of credit conditions for short-term borrowing as many adjustable-rate mortgages and loans are reset on the basis of LIBOR rates. European banks now face higher funding costs than their US counterparts. In an increasingly globalized world, this credit inefficiency can create other problems and imbalances.

We believe the question of whether we are in a recession is an irrelevant one. The more pertinent analysis is to look at the trends in the key areas of the economy - employment, productivity, production and incomes.

Of all the government data being released in the past few months, what is currently hardest to predict is the employment picture. We believe that we are at the edge either of a typical mid-cycle slowdown or an economy ready to go into recession. While we are cognizant of the resilience that this economy is showing, we do believe that the odds slightly favor a deteriorating employment picture.

Home affordability has actually decreased over the past few months, indicating that home prices are still overvalued from historic levels. Based on conservative assumptions of price-to-rents and price-to-income ratios, we believe that home prices can drop by another 15%-30% over the next couple of years to reach historic levels varying by locale.

With the USD depreciating, foreign governments are beginning to feel economic and political pressure due to their lost export competitiveness, as their products priced in local currencies become less competitive against the USD.

Many key commodities are at all-time highs in dollar terms on the back of a precipitous devaluation in the dollar since the Fed lowered rates. The world seems to be re-pricing raw goods and materials, a trend that we strongly believe will continue. We believe that the theme of the next decade will be the rise in hard assets accompanied by a secular rise in inflation.

100% in agreement.

[c1ue]

Re: analyzing the possibilities

i'm not sure that officially calculated inflation will rise very much in this scenario. high commodity prices push up energy and food, which are already up a lot, but it doesn't make it into the numbers because of the focus on "core" numbers. the broader rise in import prices might make it into the numbers, but the bls's use of substitution effects will ameliorate any feed-through into the official rate. in general, unless we see wages going up strongly, i don't see how we get official inflation rising very much. so i think the fed will remain well behind the curve on inflation-fighting, and fed funds won't be all that high.

JK,

nice post.

I did want to throw in my 4.5 cents on the above section (2 pennies not being worth face value due to copper price)

My view on the doom and gloom scenario is more like 40%, with another 30% on a '3-handle' funds rate scenario (between main scenario and doom and gloom). Main scenario likelihood is 25%, with 'goldilocks' scenario being 5%.

However, in specific reference to the blurb quoted, I actually predict official core inflation levels will stay at or below present levels.

Why? Let's look at our lovely CPI index:

CPI Component 
Weight (U.S.) 
Northeast 
Midwest 
South 
West 
Food and Beverages 
14.992% 
15.503% 
15.102% 
14.979% 
14.477% 
Housing (includes utilities) 
42.691% 
44.851% 
41.130% 
41.742% 
43.271% 
Apparel 
3.7260% 
3.982% 
3.552% 
3.660% 
3.732% 
Transportation 
17.249% 
15.558% 
17.188% 
18.155% 
17.660% 
Medical Care 
6.281% 
5.338% 
7.079% 
6.766% 
5.843% 
Recreation 
5.552% 
5.191% 
5.917% 
5.452% 
5.679% 
Education and Communication 
6.034% 
6.185% 
6.312% 
5.791% 
5.968% 
Other Goods and Services 
3.476% 
3.391% 
3.719% 
3.456% 
3.371% 

Food is already almost completely out of 'core' CPI.

Housing is also mostly a non-factor due to 23% of the 42% being 'homeowner's equivalent rent'

The 4.368% (of 42%) of housing being heating/fuel oil related will be offset by overall deflationary effects in furnishing (4.651%)

Similarly of the 17.249% Transportation, the 4.347% fuel portion will be offset by deflationary price changes in the 7.581% of vehicle purchase/rent category.

Apparel will go down; the low end will stay roughly the same while high end sales fall off the roof with net lower prices.

Medical care will stay the same. Unit price increases will be offset by lower levels of overall insurance and wealth; basically all the froth of discretionary (i.e. cosmetic) and hail mary operations will be lost and offset the 'core' medical expenses. Further down the road of course the 'core' rates will resume their previous place as the actual rate.

Recreation will go down - consumer spending decreases equal a glut of supply which in turn will drive down prices faster than normal.

Education: will go up somewhat as the unemployed continue to place faith in the 'higher education will get you more money' mantra. Note I don't refer to getting a college degree, I refer to the MBA, the JD, etc.

Other goods will also go down; lower wealth equals lower demand - until supply adjusts there will be price competition.

As you can see, there just isn't anywhere for a dollar fall/import price increase to actually impact on 'core' CPI anymore.

[jk]

Re: analyzing the possibilities

c1ue, just to add to your factors: rising oil prices actually lower owner's equivalent rent. more of the nominal rent is said to be going for heating, and less for actual rent. so when you look at "core" inflation, higher energy actually lowers the core number.

[zoog]

Re: analyzing the possibilities

...I actually predict official core inflation levels will stay at or below present levels...

Makes sense to me. I wonder if, in this scenario, there will come a time when the government's inflation numbers will be discredited even in the eyes of Joe Sixpack. It seems to be one of those things that everyone suspects, but never really says anything about. Today by various measures, real inflation is roughly twice what the CPI says. Will people be calling their congresscritters when inflation is four times reported? Will they be marching in the streets if it's ten times?

[jk]

Re: analyzing the possibilities

Makes sense to me. I wonder if, in this scenario, there will come a time when the government's inflation numbers will be discredited even in the eyes of Joe Sixpack. It seems to be one of those things that everyone suspects, but never really says anything about. Today by various measures, real inflation is roughly twice what the CPI says. Will people be calling their congresscritters when inflation is four times reported? Will they be marching in the streets if it's ten times?

eventually i expect the aarp to lead the march, since social security beneficiaries will experience the discrepancy most directly via their inadequate cpi adjustments. thoughtful boomers will be taking their benefits as early as possible, age 62, aware that the cpi adjustments will gut any advantage to waiting to qualify for larger payments.

[c1ue]

Re: analyzing the possibilities

rising oil prices actually lower owner's equivalent rent. more of the nominal rent is said to be going for heating, and less for actual rent. so when you look at "core" inflation, higher energy actually lowers the core number.

JK,

Quite right - I had not thought of it this way but your comment is absolutely correct given the methodology of "owner's equivalent rent".

In more concrete investment terms - the question is whether "actual" inflation will reflect in bond behavior or the Fed rate.

I say this because most of those who scream that the Fed has no power implicitly assume that inflation will cause bond yields to rise.

While most of us here on iTulip believe the CPI numbers are not reliable, this is still far left field type thinking in the general populace, even among mainstream investment types.

My firm belief is that the bond yields will rise, but not for 'inflation' reasons. They will rise because no one will want to lend money to the US.

Why does the cause matter if the effect is the same?

Because 'inflation' is controllable through various means such as balancing budgets, saving, etc, but unwillingness to lend is not.

[jk]

Re: analyzing the possibilities

JK,

Quite right - I had not thought of it this way but your comment is absolutely correct given the methodology of "owner's equivalent rent".

In more concrete investment terms - the question is whether "actual" inflation will reflect in bond behavior or the Fed rate.

I say this because most of those who scream that the Fed has no power implicitly assume that inflation will cause bond yields to rise.

While most of us here on iTulip believe the CPI numbers are not reliable, this is still far left field type thinking in the general populace, even among mainstream investment types.

My firm belief is that the bond yields will rise, but not for 'inflation' reasons. They will rise because no one will want to lend money to the US.

Why does the cause matter if the effect is the same?

Because 'inflation' is controllable through various means such as balancing budgets, saving, etc, but unwillingness to lend is not.

part of an unwillingness to lend is based on the idea that you will not be repaid, or at least not adequately if the value of the dollar drops enough over the course of the loan. the dropping dollar is both a reflection and a cause of a growing unwillingness to lend to the u.s. gov't.

there are other factors affecting the price of bonds, however. if the yield curve is positively sloped there is a duration carry trade - borrow short and buy long. leverage up and this can generate a lot of return. the attractiveness of this trade depends on the yield curve being stable as well as positive, so it works until or unless there is a bond sell-off and rising long rates. but as long as it works it attracts more and more capital, and thus tends to prevent the rise in long rates that would kill it - so the trade is self-reinforcing. i guess this is just a long winded way of saying it works until it doesn't.

anyway, i don't think you can separate the perception of inflation from an unwillingness to lend. the latter is an expression of the former.

[c1ue]

Re: analyzing the possibilities

JK,

I understand what you are saying.

I guess internally I have differentiated between inflation due to positive causes such as intrinsic production/population growth vs. inflation due to extraneous government causes.

Ultimately it all works out the same though.

[jk]

Re: analyzing the possibilities

JK,

I understand what you are saying.

I guess internally I have differentiated between inflation due to positive causes such as intrinsic production/population growth vs. inflation due to extraneous government causes.

Ultimately it all works out the same though.

not every price rise is an expression of inflation. if the production of a good is impaired, e.g. a refinery burns down and so the quantity of gasoline produced is reduced, the price of the good will rise. this is not inflation. similarly, if demand rises but supply is flat, the price will rise. this is not inflation. there are at least 2 definitions of inflation we can call on: inflation is a rise in the general price level; or inflation is an increase in money supply. [i think the latter has to modified by an adjustment for increases in production - thus if the population increases be a few percent, and we increase the goods available by a similar proportion, the money supply needs to grow similarly to maintain price stability.] the first definition points to an expression or symptom of the second definition. if we increase the money supply, there will be an increase in the general price level, but that increase will manifest itself over time and unequally across goods and services. i doubt you can have an increase in the general price level without an increase in money supply. anyway, what you call "inflation due to positive causes," i call price rises, not inflation.

[c1ue]

Re: analyzing the possibilities

i doubt you can have an increase in the general price level without an increase in money supply.

Sure you can - its called a hoarding panic